The explosion of stablecoins revives a debate around “free banking”

THE MOVES QUICKLY frontier of financial innovation can seem like a daunting place. Concepts like decentralization, distributed ledgers, and symmetric encryption can confuse the outsider. So researchers and regulators may have been relieved to spot parallels between the burgeoning world of stablecoins – digital tokens tied to an existing currency or commodity – and the era of free banking United States in the 19th century. Indeed, recent discussions of stablecoins have sparked a heated debate around the history of money issued by the private sector.

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Together, the dozens of existing stable coins, including Dai, Tether and USD coin, have a market capitalization of nearly $ 150 billion. As they exploded in value, their similarity to banks began to exercise regulators. Like banks, they do indeed accept deposits and promise immediate repayment; If many holders wish to withdraw their money at the same time and the issuer holds risky assets, then digital coins could collapse. On November 30, Janet Yellen, the United States Secretary of the Treasury, said tokens pose “significant risks” and called for more regulation.

Before America instituted a national currency in 1863, banks issued their own banknotes, backed by assets and redeemable in gold or silver. Stable coin critics often cite this era of free banking, and the example of unstable “wild” banking in particular, as a cautionary tale. Gary Gensler, chairman of the Securities and Exchange Commission, America’s main market watchdog, and Democratic senator Elizabeth Warren both compared stablecoins to wild cats, as did a recent article by Gary Gorton of the University. of Yale and Jeffery Zhang of the Federal Reserve. . The comparison is not so clear cut, however.

The lack of a national currency before 1863 created obvious economic inefficiencies. Dollars issued by unknown banks far from home were trading at a discount, due to a lack of information on the financial health of their issuers. For the issuing bank, circulating the notes far away was an advantage, as holders were very unlikely to show up to redeem them. This arrangement led to the emergence of crooks like Andrew Dexter, who bought out banks across Northeastern America and issued huge volumes of fraudulent notes. It was found that one bank had issued around $ 580,000, or roughly $ 13 million in today’s currency, while holding all of $ 86.48 in precious metal cash. In another case in 1838, Michigan state officials discovered that the boxes that should have contained the coins against which depositors could redeem their banknotes were filled with lead and broken glass.

Critics argue that the comparisons to stablecoins are clear. Tether, the largest stablecoin issuer with $ 74 billion in tokens in circulation, was fined $ 41 million by the Commodity Futures Trading Commission in October for claiming to be fully guaranteed by active between 2016 and 2019. (Tether responded with a statement saying that “There is no indication that Tether tokens were not fully guaranteed at all times – just that not all reserves were in cash and all in one account bank titled in Tether’s name, at all times ”, and that he had never failed to meet redemption requests.)

Yet there are also differences between stablecoins and pre-war America’s private money. Back then, anyone needing banking or currency services had to hand their financial fate over to opaque and risky institutions. In contrast, no one in the rich world is required to hold stablecoins; safer alternatives, such as insured bank deposits and cash, are readily available.

It is also not clear that wild banks are the sum of all the historical experience of money issued by the private sector. George Selgin of the Cato Institute, a libertarian think tank, compared the use of savage banking by critics of private money issuance to the use of interwar German hyperinflation by the critiques of central bank money issuance: both are extreme and negative examples, rather than representative. Scotland’s free banking system between 1716 and 1844, for example, is often cited as a period of stability. Three large banks and several small lenders all issued currencies and redeemed the notes at full value.

In addition, at least some of the problems with US free banking may have reflected poor regulation rather than a complete lack of it. Banks were often not allowed to have branch networks, and interstate banking was almost impossible, limiting the expansion of successful and trustworthy institutions. Many were also forced to hold volatile government bonds as collateral. Declines in the latter could trigger local banking crises, and have done so.

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History alone, littered with both crooks from 19th-century America and honest financiers from Georgian-era Scotland, cannot resolve the question of just how bad stablecoins are. dangerous. But perhaps a less appreciated lesson from American free banking is that while innovation is not to be stifled, the quality of regulation matters. A report released last month by the President’s Financial Markets Task Force recommended treating stablecoin issuers as deposit institutions. Providers say this level of supervision is stifling. Such regulation would, however, offer them a price: Federal Reserve accounts, which would allow them to settle payments directly, rather than grafting onto commercial banks.

An idea, detailed by MM. Gorton and Zhang and supported by Mr. Selgin and Dan Awrey of Cornell University, would make reserve accounts readily available to any stablecoin provider, provided they hold all of their assets in such an account. This would mean that the coin is fully backed by the safest possible asset: central bank reserves that carry no risk in terms of liquidity, maturity or credit. Researchers can be divided on whether too much or too little regulation has led to the extinction of feral cats. But stable coins could still avoid their fate.

Read more from Free Exchange, our column on the economy:
Measure the largest sector of the universe (November 27, 2021)
Janos Kornai understood capitalism by studying its opposite (November 20, 2021)
A thriller on Zillow (November 13, 2021)

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This article appeared in the Finance & Economics section of the print edition under the title “Taming Wild Cats”

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